Tinkering on the Margins: ECB Edition

Has the ECB finally ended its hard-money ways? You know the kind that raises interest rates twice during the crisis,allows aggregate demand in the periphery to stall, and fosters below-trend growth in money supply and money velocity. On Thursday, the ECB said it would be taking bold steps to stabilize the economy. It would start charging banks for the privilege of depositing their funds at the ECB, commence a new long-term lending program of €400 billion, quit sterilizing its bond purchases, and begin preparing for a QE program. That is quite a list, right? Many commentators are makingmuch ado about the first item since it means a major central bank will begin targeting a negative nominal interest rate. Finally, a central bank who does not fear the zero lower bound!
So does this mean the ECB has finally gone all-Abenomics on us and unleashed both barrels of the gun? Sadly, the answer is no. Its new actions will not fundamentally alter the path of aggregate demand in the Eurozone for one key reason: there has been no regime change. The ECB did not change its inflation target. Should the ECB’s new programs threaten to push inflation a tad too high expect it to tighten policy like it did in 2011. This point was made very clear by Mario Draghi in the ECB press conference :

“Meanwhile, inflation expectations for the euro area over the medium to long term continue to be firmly anchored in line with our aim of maintaining inflation rates below, but close to, 2%. Looking ahead, the Governing Council is strongly determined to safeguard this anchoring.”(HT Lars Christensen)

In other words, these policies at best raise inflation from its current low level to somewhere between 1% and 2%. That is not enough to close the aggregate demand shortfall. This is an important point. It means that even if there were further fiscal integration in the Eurozone and more active fiscal policy, such as helicopter drops, it would have little effect on the economy. The ECB would quickly offset any program that began to meaningfully raise inflation. It would cut short any robust recovery.
There has to be, however, a period of catch-up aggregate demand growth and by implication, temporarily higher inflation for a recovery to take hold in the Eurozone. This requires a commitment by the ECB to a permanent, non-sterilized monetary injection, the kind done by Japan under Abenomics and by Israel under Stanley Fisher. (No, the kind done under Ben Bernanke is not expected to be permanent and is a key reason for the sluggish recovery.)
The Germans should understand that were the ECB to allow a temporary period of catch-up inflation it does not mean long-run inflation expectations have to become unmoored. It does mean, though, the ECB would need to do something like a price-level or NGDP-level targeting. Level targeting is the kind of regime change that would fundamentally change the path of Eurozone aggregate demand since it allows for catch-up growth. It seemed to have worked for Israel during the crisis and should do wonders if tried in Europe.


In terms of the specific proposals, it is interesting to see the ECB try negative interest rates. In theory, it makes sense: move market interest rates closer to the negative natural interest rate and markets will begin clearing. And contrary to many observers claims, the mechanism for this process is not just about forcing banks to lend. It is more about incentivizing depositors on the margin to spend their money balance instead of holding them in the bank. The idea is that the banks will pass the ECB’s charge on to their customers and spur a recovery in nominal spending.


That is a compelling theory except for this problem:



Currency holdings have grown dramatically in the Eurozone and would grow even more if individuals started getting charged for their deposits. This is the zero lower bound (ZLB) problem: individuals would rather hold cash and earn 0% than hold bank accounts and earn a negative interest rate. So for all the buzz about the ECB targeting a nominal interest rate, it still has failed to solve the ZLB problem. There are ways to solve this problem without getting rid of currency. But so far the ECB has not been willing to try them.
In short, the ECB’s new programs amount to nothing more than tinkering on the margins. Unfortunately, this means more sluggish aggregate demand growth and more human suffering.


P.S. Below is a figure showing currency as a percent of M3 less currency. It reveals a sharp drop in the currency holdings during the transition to the Euro that later returns to trend. Once the Euro crisis starts the ratio starts rising. Expect it to rise more.

This piece is  cross-posted from Macro and Other Market Musings with permission.